Commentary

IPO stands for ‘it’s probably overpriced’

One big lesson from Facebook: Don’t buy new stocks

BOSTON (MarketWatch)—In the past few days, thanks to the initial public offering of Facebook, investors have learned what the letters IPO really stand for: “It’s probably overpriced.”

Truthfully, the initial public offering process is built and managed to give a predictable pop on opening day, which results in an equally predictable fallback later, which is why chasing after any initial public offering is the Stupid Investment of the Week.

Stupid Investment of the Week highlights the conditions and characteristics that make a security less than ideal for the average investor and is written in the hope that spotlighting danger in one situation will make it easier to sidestep trouble elsewhere.

Facebook
FB, +0.48%
actually was the Stupid Investment of the Week when it first registered its paperwork and planned on going public. It has actually lived up to that label since it went public Friday.

But the real issue here for investors is bigger, and it amounts to a slightly different concept: When Wall Street gets excited by something new, investors should get nervous.

The more buzz a new offering creates on the Street, the more individual investors get interested and excited and the easier it is for the guys behind these offerings to make money.

And that’s what an IPO is meant to do, fund the company and reward its founders, and make money for the people who are handling the deal.

If you’re an average investor, you’re not getting the first shares. Think of it as if it was the starting line for a big road race, where there’s a huge crowd of runners standing by the starting line ready to go … and you are part of the huge back that is queued up about a quarter-mile deep.

Even if you have the wherewithal to win the race—or at least pass a lot of the runners ahead of you—it is the guys upfront who have been promised a fast, easy start.

But continuing the analogy shows why investors really don’t want to take part in the IPO process anyway.

While there have been companies that have gone public and then gone private in fairly short order, the vast majority of companies that go public, stay public.

Thus, they’re running a marathon, and not a sprint. The Wall Street firms doing the deal and their favored investors, the ones who get to start the race at the front of the pack, can make short-term, quick-hit bets knowing that the rush behind them ensures their profits. The average guy buying in just after them is relying on “greater fool theory,” the idea that someone else will come in with even stronger emotions, willing to pay more.

Clearly, that didn’t happen with Facebook. For all of the buildup, there were plenty of naysayers out there talking about the company’s valuation. Charles Rotblut, editor of AAII Journal, said on my MoneyLife show that the stock would be attractive in the $20 or $21 range and that investors who missed out on the IPO would be better off waiting to see if the stock gets there than to buy in at a higher price just to be in early.

For everyone who points to other famous IPO pops and big-day openings as a reason to want to play initial-public offerings, they forget the truth in the numbers. If you waited three months to buy Google
GOOG, +1.08%
when it went public, for example, you were in roughly at the same price as when it first traded, and that means the front-of-the-pack price that the average guy couldn’t actually get on the first day.

But the more common examples show that after the manufacturer price pop disappears, new stocks often trend down. LinkedIn
LNKD, +7.36%
, for example, dropped about $30 per share—nearly one-third of its value—about a month after its IPO, and which was even lower five months out, before turning around and beginning a climb that now has it above the IPO level. Likewise, Groupon
GRPN, +0.77%
was off about 40% from the IPO price within a month of going public last fall, and while it popped back up for a time. It has yet to get back to the levels where it first traded and has been trending away from it.

In the 1980s, one of the first IPOs to capture public attention was for Home Shopping Network, largely because it made the company’s founders billionaires in a day, something that was unheard of at the time. I worked at the St. Petersburg Times, the local paper covering that deal, in an era before you could click on the Internet to make predictions on where a stock would go in the next day, week or month. I remember the reporters having a friendly wager on just where the stock would go from the surprising pop of the IPO. The winning bet was that the stock would go back to where it was first priced, then drop and only start to be fairly valued based on its fundamentals months down the road.

That’s how it has always been, and likely always will be.

Stocks start out trading on hype, but they end up being traded on their fundamental value.

Even if a stock were to go public at its fair-market value—something that never seems to happen—it’s probably not worth buying, simply because it’s no bargain, and it’s likely to get cheaper as the market adjusts and the hype fades and it ultimately settles in for the long run.

Hopefully that’s the lesson investors will take from Facebook; it won’t be the last IPO they talk about, but let’s hope it’s the last time the average investor is tempted to buy a hyped new stock right as it opens.

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